Building Positions

Like Bill Miller at Legg Mason, I average down relentlessly. I rarely stop out of positions as they fall and, when I do, it’s usually when they’re looking likely to fall from a high point of gain.

In general, though, I’m on the hunt for good businesses selling at a discount to their future potential. If I can increase that discount by lowering my average cost per share, I will. This requires faith in the company behind the stock, but I almost always have faith in the companies I own. I write “almost” because I have speculated occasionally on mere price movement alone. That is the exception, however, not the rule.

If you believe in a company based on thorough research, and fresh data continue supporting that belief, then a price lower than what you initially paid for a stock is a chance to improve your ultimate performance.

Knowing this, I encourage you to see the negative performance of some of The Kelly Letter’s positions from time to time as opportunities, not failures. If I’m not a seller of them as they fall, I’m a buyer. I’m building positions in the stocks.

In the early 1990s, I bought IBM (IBM) nine times before it finally bottomed out and made a fantastic recovery, as shown here:

I’ve averaged down on many stocks since then, including Deckers Outdoor (DECK), Dell (DELL), Google (GOOG), Intel (INTC), Maxtor (MXO at the time, but since acquired by Seagate [STX]), Starbucks (SBUX), and Sun Microsystems (SUNW at the time, now JAVA). Every one of the ones I already sold turned around and made money for me; I’m confident that the ones I’m still holding and/or acquiring will become profitable one day, too.

An example from outside the letter’s experience may help.

A good friend of mine loves Apple (AAPL) and he invested in the company during the end of the dot.com boom in 1999 and sold at around $30 in early 2000. The stock fell with all else tech and he waited for it to bottom out. He thought it had done so in December 2000 at $8. Then it rose.

That was the breakout, he decided. He knew the company had revolutionary products on the way. He bought at $12 the following April. The stock fell back below $8 again over the summer. On paper, he was down more than 33 percent. A bonehead, right?

Not exactly. He bought again and lowered his average cost per share to less than $10. It took months for the stock to get back up to $12 in January 2002 and then you know what happened? It fell for more than a year to less than $7 in April 2003.

After holding Apple for two years, he was down more than 35 percent. What did he do? He bought a third time, lowering his average cost per share to less than $9.

Was he early? Yes. Was he wrong? No.

Apple shares closed September 2010 at $284. My friend’s too-early, boneheaded investment gained more than 3,000 percent in less than 10 years. He was thrilled that he bought three times, but wished he’d bought ten times.

My friend and I are not traders. If you subscribe to The Kelly Letter, neither are you. We are investors. We don’t automatically stop out at -8 percent as some famous books suggest. We don’t automatically sell at +20 percent as some other famous books suggest. We find good businesses coming back from the brink, and we build positions in them.

It requires minus signs along the way and can stretch emotions, but this approach works. It doesn’t happen overnight, though, and to the instant gratification mindset of a trader, it’s unacceptable. To the investor, it’s great.

Recently, the internet has enabled short-term trading services to proliferate. Most of the “research” proffered online amounts to daily speculation, with the latest trend being the odds of certain stocks and indexes rising tomorrow. Those odds are often clustered around 50 percent, you’ll note, rendering the data all but meaningless. It’s still popular, I’m afraid, and sells well to the gullible.

Don’t fall for it. The wealthiest investors are those with multi-year time frames. That’s enough distance to provide the perspective needed to jump on short-term weakness for long-term gain. If you think you can buy today on hopes of what will rise tomorrow, and succeed at it consistently enough to overcome taxes, trading fees, and odds of failure at 50 percent, there’s nothing I can do for you.

My friend acquired shares of Apple over a two-year, rocky period that produced all kinds of doubtful headlines. You should not underestimate the fortitude it took to keep buying when papers reported that the market might never recover from the dot.com bust. Remember, Apple is a technology company and was part of the out-of-favor crowd at that time, and the dot.com meltdown was one of the worst bear markets of all time. The Nasdaq plunged 78 percent, after all. It doesn’t get much worse than that.

So, take heart when volatility sets in and weighs heavy on our portfolio. It’s a tool to be used, not a risk to be feared. Understand that a buyer prefers low prices, not high, and that low prices don’t come with happy headlines.